(iChinaStock News) Short-seller Muddy Waters recently dropped another bombshell of a report, recommending a "strong sell" on Focus Media (NASDAQ: FMCN). The stock fell about 40% upon the release of the report.

To address this topic, Xueqiu, iChinaStock's Chinese-language sister-site, conducted a microblog interview today with Paul Gillis, an expert on accounting and the VIE structure in China.

On Short-Sellers like Muddy Waters

Gillis：A famous bank robber was once asked why he robbed banks. He said "That is where the money is".

Q：How much of US investor's concerns over financial fraud of Chinese companies are real threats for investment in your opinion?

Gillis：What is the market for U.S. listed Chinese companies down over the last year? 40%? That is a real threat and a lot of that is over fraud, as well as risky structures.

Q：Bloomberg quoted a manager at Catoosa capital who said, "If I see a Muddy Waters report, I first sell and ask questions later. That's how people are doing it." How do you view this phenomenon?

Gillis：A hedge fund manager the other day told me that the only way you can lose money in his business is to go to jail. Reports like Muddy Waters are going to hit a stock, and you can't blame investors for taking advantage of that.

Q：Muddy Waters often issues reports and it seems every one has been on target. Why is MW so successful?

Gillis：They have a better track record than some. I don't know much about the organization, but it appears they spend a lot of time digging before they lob the grenades. I expect they have some big hedge funds behind them.

Q：Do you think that the business model of short-selling research firms such as muddy water is legal?

Gillis：It think it is both legal and ethical, provided you are honest. If these shorts do their research and report facts truthfully, then they help the markets work efficiently. If they make stuff up, they should go to jail.

Q：Focus Media said yesterday they want to sue Muddy Waters. What are the barriers to bringing a lawsuit against a short-seller in the US?

Gillis：Suing is easy. Winning is hard. Most companies do not want to sue shorts because they then become subject to discovery, which means the short can dig all they want in the company's records. The truth is the best defense to a libel claim.

Q：In my point of view regarding Chinese stocks under short sellers attack recently is all about ongoing corporate governance issues. What do you think ?

Gillis：There is a great deal of distrust of crony boards made up of people looking out for their own interests instead of the shareholders. That is more common in Asia than many other markets.

Q：Do you think US regulators may lack of enough regulation or inspection over these short sellers in the market? Simply because of the right to free speech, those short sellers like Muddy Waters could publish or spread whatever brings them profit, though sometimes it's just rumor.

Gillis：I expect there will be some prosecutions of short sellers. The wheels of justice move very slowing, and we will only learn about it a couple of years ago. But if they are just making stuff up to move the market, they will get caught and punished eventually.

Q：How do you now view US-listed Chinese stocks? With the price relatively low, will you consider buying?

Gillis：From a fundamental valuation perspective, there are some screaming deals out there. But the overhang of fraud and regulatory challenges must make one pause.

Q：How far away are domestic Chinese exchanges from accommodating the many companies that list abroad? What do they need to do to support such listings?

Gillis：The markets need reform first. They are not big enough. The entire market cap of ChiNext is $100 billion - Baidu alone is half of that. And the listing process needs to become more transparent and allow these companies to come to market. The better approach is probably to start by allowing some companies like Baidu to have dual listings - NASDAQ and ChiNext.

On Regulatory Oversight

Q：How will all these alleged accounting scandals influence the audit industry in China?

Gillis：I think it really threatens the audit industry. Another big scandal for one of the Big Four might push the PCOAB and SEC over the line - resulting in the China firm being deregistered - banned from auditing public companies in the U.S.

Q：What would it mean if there's one more big scandal and "the China firm is deregistered - banned from auditing public companies in the U.S."? What's the fallout and result?

Gillis：If an auditor is deregistered by the PCAOB, it can no longer audit public companies or play a significant role in the audit of public companies. For a China firm, that means they would have to give up their U.S. listed clients and could not do work on the MNCs from the U.S. It would seriously cripple any firm.

Q：What's the worst scenario if US and Chinese regulators fail to reach any agreements? Would US really take the risk of banning the auditors from China to audit US-listed companies?

Gillis：Worse case scenario is that the PCAOB jerks the registrations of all China based auditors. That leads to delisting of all U.S. listed Chinese stocks and big problems for MNCs. Read Chuck Schumer's letter to the PCOAB yesterday (on my blog www.chinaaccountingblog.com)

Q：What agreements do you expect China and US regulators to reach on joint supervision of financial fraud?

Gillis：I think the U.S. regulators are desperate to make a deal, but China is playing hard to get. I think part of that is because so many of the companies that have listed in the U.S. have ignored Chinese laws to do it. China would prefer they just give up their U.S. listings and come home.

Q：What do you think is the best possible result that US and Chinese regulators may reach?

Gillis：I think the best result will come from them working together. Chinese regulators remain in charge, with the U.S. regulators in a supporting role. Together they can make these companies follow both U.S. and Chinese law, and improve audit quality.

Q：It seems the PCAOB has not been able to establish joint inspections or effective oversight of auditors in China. In our last interview you said, that the 'doomsday scenario' is not at all likely. But are there intermediate measures that you see US regulators taking to try to establish oversight?

Gillis：I think it is getting much more dangerous. Yesterday one of the leading Democratic senators sent a letter to the PCAOB telling them that they were not doing their job and it was time to crack down. The letter is on my website: www.chinaaccountingblog.com

Q：In recent days, New Oriental, Focus Media, and Qihoo have all been questioned by short-sellers. Will this persist? Could even the unassailable like Sina, Baidu be questioned or affected

Gillis：We are moving into audit season. Audits will be mostly done in the first quarter, and that is when more frauds may come out. I expect the next few months will be very active.

Regarding Focus Media (FMCN)

Q：Do you think FMCN's response to Muddy Water last night was believable and sufficient?

Gillis：I think FMCN is eventually going to have to ask an independent board committee to investigate all the acquisitions. They will hire lawyers and accountants and get to the bottom of it. It will be expensive, but necessary.

Q：Muddy Water said FMCN has written at least 21 acquisitions down to zero and then given them away for no consideration. Is the accusation grounded? Can you explain about the normal write down process?

Gillis：It is really hard to assess the accusation. From an accounting standpoint a company must assess whether the carrying value of previous acquisitions can still be justified. They do that using a DCF model. If they cannot justify carrying the balance, they must write off.

Q：Shanda's board of directors recently approved plans to privatize the company again, with the CEO stating the company is undervalued in America? The CEO of GEDU said the same. How do you view this matter?

Gillis：Many Chinese companies are seriously undervalued. CEOs must be very disappointed with how the market is treating them. I expect we see more companies deciding to go private. Some may later re-list in Shenzhen.

Q：If a company is hit by a short-seller report, how should it respond? How could a legitimate company best assure worried investors?

Gillis：Companies have to respond. Unless the allegations are ridiculous, they are pretty much stuck with spending a lot of money to have an investigation done.

Q：Some of the short-sellers reports we've seen have been targeting companies on the operation level. But Muddy Waters is digging up the historical 'wrong-doings' of some of the FMCN officials. How do this kind of historical fact tend to influence the long-term stock price of a company?

Gillis：What Muddy Waters is doing to FMCN is going after the integrity of the insiders. If their allegations prove true, they do serious damage to those people and any company they are associated with.

Q：What is the worst consequence do you think to all US Chinese listed companies, if what Muddy Water's allegation was right?

Gillis：If Muddy Waters is right, this is going to get everyone focused on the promoters and boards of the companies, wondering if they are ripping off shareholders. The whole issue of corporate governance of these companies will be front and center.